Warwick Lightfoot is Head of Economics at Policy Exchange
For the second time in the twenty-first century, there is a full-blown economic crisis that is testing advanced economies in a manner not otherwise experienced since the Great Depression in the 1930s. The adverse shock generated by the public health response to Covid-19 has brought about a loss of economic activity on a scale that will test the foundations of market economies.
What is the best policy response? Policy Exchange has published a paper today, A pro-growth Economic Strategy, that sets out an ambitious agenda of borrowing, reform of the central bank’s remit and supply-side improvements.
At its heart is the recognition based on our polling that the public do not want a return to austerity, and there is no need to do so. Only 16 per cent per cent of people polled support cuts that would affect public services. The Bank of England’s inflation target of two per cent should be ditched, the paper also argues, and replaced with a pro-growth four per cent nominal GDP target.
The context is a decade-long shift in macro-economic thinking. In the crisis that started in 2007, monetary policy run by central banks – which focuses on interest rates and the supply of money and credit – was ineffectual as a stimulus to economic activity.
Central banks have worked hard over the last 10 years to breathe life into monetary policy to make it an effective tool of macro-economic demand. Yet after a decade of forward guidance, credit easing and quantitative easing, it was clear even before the Covid-19 crisis that in the event of an adverse economic shock, requiring a powerful stimulus to stabilise demand, monetary policy had run out of road.
Instead, policy makers would have to turn to fiscal policy to stimulate their economies in the same way that they were forced to do in 2007-8. Governments would have to accommodate budget deficits, tax receipts would have to be allowed to fall and spending would have to rise.
There are people who have serious reservations about government borrowing. It is perceived as a rake’s progress into debt that inevitably leads to higher debt service costs that will result in a future increase in the tax burden. There is a particular concern about the amount or stock of total government debt ,and the way that annual budget deficits incrementally add to it.
This focus on government debt within public finance, however, is at the best of times an erroneous distraction from the true cost of public expenditure. Public debt and budget deficits in themselves are of little concern provided the cost of servicing the debt is manageable, and the cost of debt service does not become an awkward issue in terms of public spending itself.
In the present crisis, the costs for governments of using debt and fiscal policy are at their lowest in modern financial history. The combination of very low inflation and a surplus of international savings has resulted in extraordinarily low interest rates and long-term government bond yields.
This means that governments are able to take fiscal measures that are the equivalent of ten per cent of GDP and more. They will be able to take further measures to ease the restructuring of the economies and to stimulate demand when it is needed.
Over the last ten years, government debt has risen sharply in relation to national income in most advanced economies. Yet the cost of financing the debt service charge involved has fallen. Between 2010 and 2020, the cost of servicing UK debt fell from around 2.5 per cent of GDP to around a little under 2 per cent. In Italy, the ratio fell from over 4 per cent to about 3.25 per cent. For the OECD as a whole, the ratio has come down from around to two per cent to around 1.75 per cent. These falls in debt service costs have taken place over a decade when public debt in OECD countries has risen by 28 per cent to $17 trillion.
At the time of the March Budget, the Office for Budget Responsibility estimated that the cost of servicing the UK debt would be £34 billion or about 1.4 per cent of GDP. Following the impact of the crisis, the OBR revised this estimate. But despite an expected increase in borrowing, it revised down its estimated cost of servicing the debt to take account of a further fall in interest rates and lower inflation, which further lowers the RPI used for the inflation index linked part of the national debt.
In re-estimating the costs of public debt in the context of a large increase in debt, the OBR is not alone as a public authority in lowering its expected cost of debt service. The Congressional Budget Office, for example, has published Interim Economic Projections for 2020 and 2021. It argues that interest rates are expected to remain low because of subdued economic activity, weak labour market conditions, actions taken by the Federal Reserve, and an increase in investors’ demand for low-risk assets.
The level of UK bond yields in the modern world of integrated capital markets are heavily shaped by the international flow of funds, international expectations about inflation and interest rates rather than specific factors affecting the UK. The Federal Reserve and the US Treasury market dominate international capital markets and the level of international rates is determined in New York. Interest rates are therefore unlikely to change for the reasons that the CBO has identified. This is not, in other words, a time to hold back on borrowing.